by William Isaac for Directorship magazine (published by the National Association of Corporate Directors)

The FASB is implementing important reforms to correct accounting problems that worsened the recent financial crisis.

While the waters of the financial system were calm in early 2007, trouble was brewing just below the surface. Many changes on the accounting and regulatory fronts had been implemented over the prior fifteen years that were about to be put to the test.

  • Accounting rules adopted by the Financial Accounting Standards Board and blessed by bank regulators and the Securities and Exchange Commission allowed trillions of dollars of loans to be “securitized” and removed from banks’ books, thereby escaping regulatory capital requirements.
  • The SEC and bank regulators adopted enormously complex, backward-looking models to determine the adequacy of bank capital and loan loss reserves, which allowed large commercial and investment banks to leverage their capital excessively.
  • Mark-to-market accounting (MTM) was implemented by the SEC and the FASB over vigorous objections from the Secretary of the Treasury and the chairmen of the Federal Reserve and Federal Deposit Insurance Corp. (FDIC).

It’s now widely recognized by government leaders and financial experts throughout the world that these failed policies played a major role worsening the financial crisis that began in late 2007. We relied excessively on markets and models to regulate banks instead of developing a first-class supervisory regime with proper checks and balances.

Important reforms are now being implemented. Accounting rules on securitizations have been tightened significantly, making it much more difficult to remove loans from bank balance sheets and escape capital requirements. Bank capital and loan loss reserve models are becoming more forward-looking and are relying more on seasoned judgment. These represent important steps in the direction of improving stability and soundness in the financial system.

The FASB’s approach toward MTM accounting has lagged far behind this reform movement. The FASB, almost inexplicably, proposed last year to expand MTM accounting to cover all bank loans. This would have essentially shut down bank lending, except for very short-term loans to businesses with impeccable credit ratings.

The FASB’s proposed expansion of MTM accounting to include loans held to maturity drew a firestorm of criticism from bank regulators, the banking industry, the vast majority of bank investors and the International Accounting Standards Board.

Apparently, the FASB’s proposed expansion of MTM generated a good deal of controversy within its own ranks. The chairman of FASB submitted his resignation and the trustees of FASB decided to increase from five to seven the number of members on FASB’s board.

Finally, the FASB recently announced its intention to abandon its proposed expansion of MTM to include loans held to maturity. This represents an important step toward a more responsible accounting system that promotes financial stability.

Former Secretary of the Treasury Nicholas Brady was prophetic when he wrote FASB on March 24, 1992, cautioning that MTM accounting would introduce a great deal of volatility in bank earnings and capital and would inevitably lead to severe credit crunches.

That is precisely what happened in 2008. Panic set in and market prices collapsed for a period of six months before beginning to recover. MTM accounting forced banks to write assets down to temporary panic prices, senselessly destroying over $500 billion of bank capital. Millions of people throughout the world lost their jobs, homes and life savings. We are still struggling to recover from the severe worldwide carnage.

Proponents of MTM accounting argue that returning to historical cost accounting will reduce transparency. Nothing could be further from the truth.

Historical cost accounting requires that assets be booked at cost, never written up in value, and be written down whenever there has been a permanent diminution of their economic value based on analysis of reasonably expected cash flows. For assets that have a market price, that price is required disclosure in footnotes to the balance sheet.

MTM accounting simply does not work when markets cease to function as they did in 2008. Nor does it work for assets, such as loans to small businesses, that are unique and difficult for outsiders to value and therefore do not trade in sufficient volume to establish a fair price.

One can only hope that the FASB’s reversal on expanding the scope of MTM accounting is but a first step and that other reforms will follow. MTM accounting has no place in the banking system apart from securities held in trading accounts.